State Tax Trend No. 7: Collapsing Unemployment Insurance Systems

June 21, 2012

Record high levels of unemployment and record low reserve funds have placed great pressure on the federal-state unemployment insurance (UI) tax and benefit system. In some states, benefits can be drawn for as long as 99 weeks, and accompanying growth in long-term unemployment is exhausting states' funds dedicated to supporting UI programs, says Joseph Henchman, an attorney and policy analyst at the Tax Foundation.

As a consequence, states are borrowing from the federal government in order to fund their programs and continue paying out benefits. The scale of this borrowing is enormous, and the statute-imposed consequences are substantial for employers and workers.

Between 2008 and 2011, $174 billion was paid in unemployment taxes while $450 billion was paid out in benefits, a gap of $276 billion.

Over the past three years, 34 states and the U.S. Virgin Islands exhausted their unemployment insurance trust funds and borrowed from the federal government to pay benefits.

While some states have repaid their loans and others are no longer borrowing additional sums, as of May 2012, 22 states and the U.S. Virgin Islands had outstanding loan balances totaling $30.45 billion.

Crucial to understanding the impact of this borrowing are the stipulations under which the loans were made.

Federal unemployment taxes are ostensibly levied at a 6.0 percent rate on the first $7,000 of each worker's earnings.

Yet if a state's program meets federal guidelines, state UI taxes are credited against up to 90 percent of the federal tax, meaning that the tax rate becomes 0.6 percent.

However, when a state UI program is insolvent for an extended period of time, this 90 percent credit is reduced by 0.3 percentage points per year.

Thus, Arizona's UI program, for example, has been insolvent for one year, so employers in that state will see a reduction of 0.3 percentage points of their credit against federal UI tax, thereby creating a 0.9 percent federal tax.

Twenty-six states and the U.S. Virgin Islands will see federal UI credit reductions in 2012 due to insolvency. Unemployment insurance was meant to be a countercyclical Band-Aid during recessions. But a program that raises taxes on employers and employees when that cash is most needed will perpetuate, rather than numb, the pain of a recession.